Vesting conditions are conditions that must be satisfied in order for the employees to have the ability to exercise their options. There are two common types, service-based and performance-based. Service-based means the employees must work for the company throughout the investing period. So if the options are granted with a three year vesting period, the employees must remain in continued service for the three year period before they can exercise their options. This is great for the company as it prevents their employees leaving whilst reaping the reward from the options. Performance based means that a certain number of options or all of the options can only vest if specific performance targets are achieved. A company may set a hurdle EPS target, for example. This is usually set on a sliding scale where the first EPS target will allow 20% of the options to vest, for example, the next target and additional 20% and so on and so forth. EPS targets are common for senior managers as they have the ability to make strategic decisions about the business that will ultimately determine if the EPS target is achieved. For performance-based options, the company will set a date to achieve the targets by, if not met, then the employees will not be able to exercise those options and the options will lapse and are never vested. These conditions do add some complexity when calculating the expense. The stock options expense needs to reflect the number of options expected to vest. Beforehand, the stock options expense was based on the fair value of the options, number of options and vesting period. But now we need to adjust this expense depending on the number of options that are expected to vest. For example, we are told that 300 options are granted at fiscal year zero with a fair value of $1 and a vesting period of three years. Now, let's assume that the options are service based and the company has good data to predict the level of staff turnover. They expect staff turnover of 10% over a three year period. If staff leave, they must forfeit their options. So even though the company has granted 300 options, we actually only expect 270 of these to vest with 30 being forfeited. Now we'll calculate the stock options expense using the number of options expected to vest. That is 270 options multiplied by the fair value at the data grant, multiplied by one over three so that we only include the allocated proportion of this expense in fiscal year one. This gives an expense of 90 being recognized in the income statement. In year two, the company has increased the expectation of staff turnover. Presumably this is because more staff left during year one than anticipated. So the number of options expected to Vest has now decreased to 240. We always go by the number expected to vest, which in this case is now 240. So we take our 240, multiply it by the fair value of the options at grant date, and this time we multiply it by two over three to cover two years, since we are two thirds of the way through the vesting period. This gives us 160, but 90 of that has already been expensed in the first year. So we calculate the difference and expense the amount in year two through the income statement. By the end of year three, the options are at the end of the vesting period. The company now knows how many staff are left in the firm and it turns out that their prediction in year two was correct. The number of options which vest is 240. So we take the 240 options, multiply it by the fair value of the option. This always stays at $1 in this example, and now we're all the way through the vesting period, so we multiply that by three over three. This means the cumulative expense stays at 240. We have already recognized 90 in year one and 70 in year two. If we deduct both of these from our cumulative expense, this leaves 80 left to be recognized through the income statement in year three. A few points to note the number of options expected to vest is based on internal information and we'll be calculated by the management of the company. In this example, it's is service based and only based on how many employees are expected to remain in employment. There may be different or multiple vesting conditions. For example, if the vesting conditions are performance based, their management need to decide if they're on track to meeting those targets. Therefore, at specific milestones, this will determine the adjustments made to the number expected to vest.
